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The post-Brexit recession risk calls for more stimulus, but does the Bank now have any ammunition left?

04/08/2016

Azad Zangana

Senior European Economist and Strategist

A sharp drop in economic activity as reported by private business surveys has pushed the Bank of England’s (BoE) Monetary Policy Committee (MPC) to take action to provide stimulus.

What’s happened?

The BoE has today cut interest rates from 0.5% to 0.25% - the first time in seven years. The MPC has also decided to restart quantitative easing (QE), by adding £60 billion to the currently held £375 billion stock of assets – the first addition to the programme in four years.

In addition, a Term Funding Scheme (TFS) has also been introduced to help banks pass on interest rate cuts to borrowers, while £10 billion of corporate credit will also be purchased (over the next 18 months) to directly lower the cost of funding through credit markets.

Brexit impact

Concerns over the UK’s exit from the European Union appear to have hit household and business confidence, causing important spending and investment decisions to be put on hold.

In presenting its latest quarterly Inflation Report, the BoE has slashed its GDP growth forecast for 2017 from 2.3% to just 0.8% (matching the Schroders forecast).

The Bank has also raised its near-term inflation forecast, as it expects the depreciation in the pound to raise the cost of imports, which eventually feed through into higher prices for goods.

However, in its decision today, the MPC has placed more weight on the expected slowdown in growth, rather than the pickup in inflation.

It believes that the currency effect on inflation will be short-lived, while the implications from slower growth could be more powerful over the medium term.

Adjustment to our forecast

In the MPC’s meeting minutes, the committee stated that a majority of members are minded to cut interest rates further, to close to but above zero if the incoming data proves to be broadly consistent with their latest forecasts.

Given our growth forecast is very similar to the BoE’s, we are today changing our forecast to include a further cut in interest rates to 0.1% for November.

Following the BoE’s announcement, the pound has fallen around 1.25% against the US dollar and 1.12% against the euro. The FTSE 100 has reacted positively, rising 1.4% and the cost of borrowing for the government (gilt yields) has fallen to new record lows.

Will today’s measures be enough?

The measures announced today will at best cushion the slowdown in economic growth expected in coming months, but in our view – and as has been stated by outgoing MPC member Martin Weale – would only marginally stimulate the economy.

Although BoE Governor Mark Carney said today that policy stimulus targeted domestic demand and not the currency, we do not think he would have been disappointed in the slip in sterling.

This will be helpful for exporters in the long term, but painful for consumers in the near term.

Our central forecast is for the UK to avoid a technical recession, but we do place a 40% probability on the likelihood that the economy falls into recession.

Carney stated that all of the measures announced today could be expanded if required. However, we are very doubtful that additional QE, TFS or purchases of corporate debt will have any noticeable impact on the economy.

Instead, we believe the government now needs to step forward to introduce significant fiscal stimulus.

Chancellor of the Exchequer Philip Hammond is due to “reset” fiscal policy, which we hope will include tax cuts aimed at boosting both corporate investment and household consumption.

Conclusions

The BoE’s decision to provide more stimulus than was expected by markets suggests the MPC is concerned over the economic outlook following the EU referendum.

The measures taken today will help ease the pain of the Brexit shock, but they are certainly not a panacea.

Fiscal policy must now move from austerity to stimulus. The BoE is running out of ammunition, and must be realistic with how much more support it can provide.

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